I wrote a piece in the New York Times that appeared yesterday along with Mark Thoma and John Cochrane. The question was “Should the Fed Risk Inflation to Spur Growth?” My answer was that the Fed should always keep an eye on inflation as that is its mandate. But, at present, outside of food and energy prices that the Fed can’t control, inflation is not likely to become embedded due to high unemployment (as well as low wage growth and slack in industrial utilization).

The real question is how the Fed complies with its other mandate, helping the economy reach full employment – a mandate which I should point out the ECB doesn’t have.

Here’s the crux of the piece:

But what can the Fed do? Usually the Fed lowers interest rates to stimulate the economy. But, the Fed has said the federal funds rate will be effectively 0 percent through late 2014. So the Fed has resorted to less proven, less effective means like buying up Treasury bonds or informing bond markets that it intends to keep the federal funds rate at 0 percent for longer. This won’t cut it.

So Bernanke has told Congress the Fed cannot do it alone, without interfering in fiscal policy by making specific recommendations. Congress needs to do more to bring down the unemployment rate, the broadest measure of which is 15.3 percent. But Congress has failed to live up to its responsibilities. Exasperated with political gridlock on Capitol Hill, everyone has turned to the Fed as economic savior.

To be sure, there are a lot of things the Fed could do. There are many more unconventional measures it could take like targeting interest rates via rate caps, something I call rate easing. It could also buy more mortgage securities or buy municipal bonds. One measure many support is targeting nominal GDP as an explicit Fed policy.

These are all things the Fed has considered doing. (See here.) For example, San Francisco Fed Chief John Williams has endorsed the targeting of nominal GDP as a potential Fed move. The question is whether these new untested monetary policy measures will be effective in an environment of low credit demand growth and high unemployment. I don’t believe they will be. And the Fed is not convinced they will be either. So they have resisted further measures beyond those they began last year. Tim Duy believes QE3 is out. I think he’s right.

But the Fed does have an full employment mandate. So if and when the economy turns down enough, the Fed will act and act aggressively. But by that time recession will have taken hold.

Moreover, as I said three years ago, high budget deficits are politically unsustainable. Eventually Congress will move to reduce them by any means necessary. Here’s how I put it in 2009:

So to recap:

A depression was borne out of high levels of private sector debt, the unsustainability of which became apparent after a financial crisis.

The effects of this depression have been lessened by economic stimulus and government support.

Government intervention led to a reduction in asset price declines, which led to stock market increases, which led to asset price stabilization and more stock market increases and eventually to asset price increases. This has led to a false sense that green shoots are leading to a sustainable recovery.

In reality, the problems of high debt levels in the private sector and an undercapitalized financial system are still lurking, waiting for the government to withdraw its economic support to become realized

Because large scale government deficit spending is politically impossible, expect a second economic dip within three to four years at the latest.

That’s what the fiscal cliff is all about.

My conclusion: The Fed cannot fulfill its mandate in getting the United States to full employment without active policy efforts from fiscal agents irrespective of whether it tries new untested monetary policies. But fiscal agents are working against full employment as state, local and federal governments have been shedding workers since President Obama took office. There has been a record decline in government employees under President Obama.

I anticipate federal fiscal policy will become even more contractionary in 2013 when the fiscal cliff is reached. And the US economy will slip into recession – if it hasn’t done so already.

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.

11 Comments

There will also be an recessionary impact from business that holds back any expansion to avoid getting caught in a recession. That will reduce any growth and actually encourage others to cut back fearing a recession. The problem is that while the Fed have been going overboard to try and stimulate the economy the real problem is congress who only seem to be interested in cutting back, and have totally walked away from their responsibility to manage the economy through fiscal measures.

My argument here is that you need higher capacity utilization and/or food and energy prices to produce so-called cost-push inflation. If prices rise without a commensurate rise in income, it just leads to recession and is unsustainable.

Just to be clear, there is a certain amount of hysteresis involved in employment markets, meaning that unemployment remains high in the wake of a negative shock. But this is asymmetric because unemployment rises quickly when the economy has a negative shock but only goes down slowly afterwards because of the hysteresis.

Right there you can see there is no linear trade-off between inflation and unemployment, meaning that you can have low unemployment and low inflation as the Swiss do. So I don’t believe in NAIRU or the natural rate of unemployment paradigm. I think that’s a failed way of looking at the situation.

But what is clear is that low wage growth and inflation spell recession in this environment. And that combined with the hysteresis of labor markets means high unemployment in the absence of some sort of government-aided employment queue.

You said “inflation is not likely to become embedded due to high unemployment.” My point is that high unemployment has nothing to do with it.

I think one problem is that short-run unemployment is a result of a mismatch between the specific types of labor available and the specific types of labor demanded. During the housing boom, for example, too much labor switched to the housing market (construction, real estate agents, mortgage brokers, etc.). Then the demand for such types of labor declined quite a bit, resulting in unemployment.

The unemployment situation will only improve when the labor market adjusts so that the supply and demand return to some sort of balance. Unfortunately, the government is making the adjustment take much longer by providing extensive unemployment benefits (giving less incentive to change careers or industries), raising the minimum wage (preventing the market from clearing), implementing costly regulations like ObamaCare (reducing demand for labor), etc.

In any case, it is not difficult to understand how there could be inflation and high unemployment in such a situation. Inflation is a monetary phenomenon. It isn’t a simple phenomenon to understand though. We seem to be having the same problem as Japan, which has had very “inflationary” policies for quite some time, yet little inflation (and some deflation). Maybe it is a Sisyphean effort that should be abandoned. Maybe we should just let the market decide what interest rates are appropriate.

Inflation is not a monetary phenomenon though. It’s about the relative scarcity of real resources given a given level of demand for them. That’s why Japan has been able to increase base money without any appreciable impact on the real economy in terms of inflation.

“Hyperinflation is an economic malady that arises under extreme conditions: war, political mismanagement, and the transition from a command to market-based economy – to name a few. In each of these circumstances, there are barriers to the recording and publication of reliable inflation statistics. As we discovered over the course of our investigation, overcoming these barriers was an arduous and painstaking process. In light of this, it is little wonder that no one has been able to fully and accurately document every case of hyperinflation.”

“My answer was that the Fed should always keep an eye on inflation as that is its mandate. But, at present, outside of food and energy prices that the Fed can’t control, inflation is not likely to become embedded due to high unemployment (as well as low wage growth and slack in industrial utilization).”

Oil is priced in USD. When you perform QE, you devalue it, causing people to want more USD for the same oil. The rise in oil prices over the past two years have been a result of this process. The Fed most certainly influences thse markets.

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